Role of financial markets:

A general overview of functions and benefits

Sonja Juko, Senior Advisor for Monetary Policy and Financial Markets, Center for International Central Bank Dialogue

Disclaimer: Views expressed are those of the author and do not necessarily represent the views of Deutsche Bundesbank
Objective

I Start discussion on financial markets by highlighting the broader context

I Brainstorm on motivation behind financial market development

I Review general function of financial markets as an element of the financial

system

I Review function of specific financial market segments

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Context of discussion
Financial System: Basic structure

I Financial markets (and their

development) need to be seen in the
broader context of the financial system Intermediaries

I A financial system consists of

FA/FL
− Money (means of payment) FA/FL FA/FL
− Financial instruments Financial System
− Financial markets FA/FL FA/FL
− Financial institutions FA/FL

− Financial infrastructure (payment systems)

Markets

Payment system

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Questions

(1) Why is it desirable to develop (national) financial markets? What are benefits
of (developed) financial markets?

(2) What general functions do financial markets serve?

(3) Why is it desirable to have/develop various financial market segments? How

do the functions of financial market segments differ? Which financial market
segments cater for what needs?

(4) What characterizes (efficient) functioning financial markets?

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Benefits of financial markets REFLECTION

I Why is it desirable to have or develop (national) financial markets? What are

benefits of (developed) financial markets?
− From a general perspective?
− From the perspective of CBs?

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Function of financial markets REFLECTION

I What functions do financial markets serve? What distinguishes financial markets

from financial intermediaries?

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Benefits of financial markets
The finance-growth nexus

Contribute to efficient allocation of economic

resources

Support economic growth and resilience How?

Promote poverty reduction

I … confirmed by research

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Function of financial markets
General functions: Financial services

I Financial systems provide several services to the economy (economic agents)

• Allows exchange (flow) of funds between lenders, investors, and borrowers
Allocate capital
• Financial systems provide different channels to allocate funds: directly (via
(funds) markets) or indirectly (via intermediaries)

• Provides transfer mechanisms to channel funds between economic agents

Making
• Payment systems and providers of payment system services play crucial role in
payments channeling funds (electronically) by clearing and settling financial transactions

Mobilize • Provides saving instruments

savings • Pooling funds that can be matched with borrower needs

Monitor use of • Funds exchanged take the form of different financial assets and liabilities that
funds can be traced and analyzed

Transform risks • Provide hedging instruments

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Function of financial markets
Distinction between financial markets and intermediaries

I In contrast to financial intermediaries, financial markets

I … match saver and borrower (needs) directly

− Example: A company issues a share to raise capital for an investment project. The shares
are bought by private households in order to save for retirement

I … allow financial instruments to be traded

− Example: Housholds who own stocks can sell them when to get their invested funds
(current market value) back

I Prices reflect demand and supply (bying & selling) of financial market
participants

I Financial market transactions take place between a variety of different market

participants including households, firms, government, financial intermediaries

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Function of financial markets
Special functions of financial markets

I In contrast to financial intermediaries, financial markets provide additional services

Risk sharing Liquidity

Intermediaries

Savers Financial System Borrowers

Markets
Payment system

Payment system

Information

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Function of financial markets
Special functions of financial markets (cont.)

Liquidity Risk sharing Information

• Refers to ease with • Allowing savers to hold • Parts of the financial

which assets can be a portfolio of different system specialize in
exchanged/sold without assets information gathering
loss in value (‚diversification‘) and monitoring
• Special arrangements
• The higher the liquidity • The more developped to solve problem of
the easier economic the financial system the asymmetric
agents can (re-) allocate more risk can be information (
funds at any given time shared/diversified financial regulation)
• The better the available
information the lower
information (and
transaction) costs

• the more willing savers will be to provide funds to potential borrowers

• the greater the ability to raise funds

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Function of financial markets Reflection
Special functions of financial markets (cont.)

I How do the scenarios differ with respect to the degree of risk sharing, liquidity
and information?

Imagine SCENARIO 1: You give SCENARIO 2:The company SCENARIO 3: The

your friend‘s your savings to the of your friend gets a loan company of your friend
company company of your friend from the same bank issues tradable bonds. You
wants to where you keep your purchase some bonds
borrow … savings on an account using part of your savings
Risk sharing

Liquidity

Information

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Function of financial markets
Role for local financial markets

• Local financial markets allow governments to finance fiscal deficit without

1
having to resort to foreign borrowing

• Local financial markets support conduct of monetary policy (provide

2
instruments and give information)  arena for action & source of data

3 • Local capital markets improve availability of long term financing

4 • Local financial markets improve access to local currency assets

• Local financial markets improve financial deepening and increase efficiency

5
of capital allocation

6 •…

See IMF (2014): The Development of Local Capital Markets: Rationale and Challenges

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Function of financial markets
General role with a view to different CB functions
CB functions
(e.g. monetary policy, FX reserve management, financial stability etc.)

• Data collection and analysis of monetary and financial

Data source developments provides basis for policy formulation
(i.e. decisions) and implementation (i.e. operations)

• Monetary & financial developments may undermine

Source of risk achieving the policy objectives or may call for
particular CB actions
Monetary & Financial system
Arena for • Monetary operations take place within the monetary
action and financial system

Venue for
• Monetary policy stance is transmitted through the
policy monetary and financial sector
transmission

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Function of financial markets
Special role for monetary policy transmission

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Function of financial markets: Specific market segments REFLECTION

I Why is it desirable to have/develop various financial market segments?

− From a general perspective?
− From the perspective of CBs? (Which financial market segments are of particular relevance
with regards to your tasks at the CB?)

I What are functions of specific financial market segments? How do the functions
of financial market segments differ? Which financial market segments cater for
what needs?
− Money vs capital market
− Equity vs debt market
− Cash vs derivative market

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Function of financial markets: Specific market segments
Overview of financial market segments

I Different financial market segments cater for different needs/serve different

purposes

Financial markets

Money markets Capital markets FX market Derivatives market

Equity market Debt market

Primary market Primary market

Secondary market Secondary market

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Function of financial markets: Specific market segments
Distinction of financial market segments

• Dinstinguishing characteristic: Purpose for savers and borrowers

Primary
• Primary markets are markets in which financial market products are initially sold.
vs Their main purpose is to raise funds.
Secondary • Secondary markets are markets in which financial market products are bought and
sold among investors. They provide liquidity and facilitate risk and maturity
markets management

• Distinguishing characteristic: Legal rights and obligations attached

Equity
• Equity instruments provide a claim to profits and assets of a firm. Investors become
vs (partial) owner of the company and are involved in the governance of the firm
Debt • Debt market instruments are claims which requires the borrower to repay the
borrowed amount (the principal) plus a rental fee (the interest) either at once or
markets periodically over a fxed period of time (maturity)

Money • Distinguishing characteristic: maturity of the traded financial instruments

• Maturities of less than a year (short term) are issued and traded on the money
vs
market
Capital • Instruments with a maturity greater than a year (longer term)are issued and traded
markets on the capital market

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Function of financial markets: Specific market segments
Distinction of financial market segments: Bond & credit market

I Bond and credit market are terms often used interchangeably

− Bond market is actually only a segment of the credit market
− Credit market refer to a market segment through which economic agents (companies and
governments) issue debt such as bonds, short-term commercial paper
− Instruments are primarily issued to cover an entity’s financing needs

I In the broader sense, the credit market also includes derivative markets
− designed primarily to transfer risk
− traded instruments: futures, options and swaps

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Function of financial markets: Specific market segments
Distinction of financial market segments (cont.)

I Financial markets can be distinguished further

• Cash market: Settlement takes place „immediately“ (accord. to

Settlement of market convention eg t+2)
financial • Derivatives market: Settlement takes place at prespecified future
transactions date (‚Future‘) or within a prespecified time period (‚Option‘)
 not the only distinction of derivative markets! Main characteristic: risk
transfer

Currency/Unit
• FX market
of payment

• Public issuer e.g. government bond market, municipal bond

Issuer market
• Private issuer: Corporate bond market, stock market

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Characteristics of efficient functioning financial markets Reflection

I What are basic characteristics of efficient functioning financial markets?

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Characteristics of efficient functioning financial markets
General considerations (1)

I Functioning financial markets Regulatory regime

build on „the four Is“
− Issuers with short, medium and Infrastructure
longer-term financing needs (
supply)
Supply
− Investors with a need to place (Borrower)
savings ( demand)
Demand
− Intermediaries bringing issuers
Primary
market: Issuers Financial (Lenders)
and investors together
− Infrastructure providing Secondary Market Investors
conducive environment for market:
transactions, settlement and price Investors
discovery
I … in the context of a regulatory Intermediaries
regime providing the basic
framework

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Characteristics of efficient functioning financial markets
General considerations (2)

(1) Competitive market structure

(2) Low transaction costs

− incl. search/information costs, legal costs, transaction & settlement costs, etc.)

(3) Accurate, widely available information

− in particular, accurate pricing of financial assets

(4) Investor protection

(5) Robust/safe market infrastructure

(6) Heterogeneity among market participants

(7) (Low level of fragmentation)

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Key takeaways

I Financial markets (and their development) need to be seen in the broader

context of the financial system

I Financial markets provide special services to the functioning of a market-based

economy, promoting the general economic development ( finance-growth-
nexus)

I Specific financial market segments serve different functions and cater for
different needs of economic agents

I Efficiently functioning financial markets build on a diverse issuers and investor

base which deal with each other with the support of various financial
intermediaries via a range of infrastructures on the basis of a regulatory
framework

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References

− OECD (2017): The role of financial markets, in: Understanding financial accounts, Chapter 2, pp 61-90.
https://www.oecd.org/publications/understanding-financial-accounts-9789264281288-en.htm
− Sahay, Ratna et. al. (2015): Rethinking financial deepening: Stability and Growth in Emerging Markets,
IMF Staff Discussion Note, SDN/15/08 https://www.imf.org/en/Publications/Staff-Discussion-
Notes/Issues/2016/12/31/Rethinking-Financial-Deepening-Stability-and-Growth-in-Emerging-Markets-
42868
− The World Bank (2005): Financial Sector Assessment – A Handbook
http://documents.worldbank.org/curated/en/306701468337879923/Financial-sector-assessment-a-
handbook#

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 Contact: sonja.juko@bundesbank.de

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